Co-authored with Felix Martin
The Office for Budget Responsibility forecast in March that the UK economy would grow by 1.7 per cent in 2011, and that the government could meet its target of eliminating the structural deficit by 2014-15. But the economy has underperformed these forecasts by so much that it now seems growth will be little more than 1 per cent, and the target not achieved until 2016-17. A recent speech by David Cameron showed he was preparing to announce what a report from Barclays Capital neatly called “two years’ slippage in eight months”.
So we have embarked on Plan B – printing money, though only to a modest extent, a £75bn programme of “quantitative easing” announced by the Bank of England on 6th October. For those who never believed in Plan A – chancellor George Osborne’s original view that cutting public spending would automatically produce economic recovery – resort to monetary policy is the start of a more interesting debate, about whether monetary policy alone can engineer a recovery from recession.
Milton Friedman said yes, arguing that it was the Fed’s failure in 1930 to pursue “open market operations” on the scale needed that deepened the slump. Against this view is Keynes’s famous retort: “If, however, we are tempted to assert that money is the drink which stimulates the system to activity, we must remind ourselves that there may be several slips between cup and lip.” Keynes postulated two possible slips.
Firstly, monetary policy may not succeed in reducing the interest rates faced by borrowers. The relevant interest rate is of course the risky interest rate faced by corporate borrowers – not the risk-free gilt yield. So the question is whether QE will reduce not only gilt yields but also the risky interest rate.
Secondly, lower interest rates may not stimulate growth in lending and economic activity. This is a question of demand – even with a lower risky interest rate, will demand for borrowing increase? This is the only channel whereby the interest rate can drive spending.
So how did the first round of quantitative easing, which pumped £200m into the economy between March 2009 and February 2010 fare on these two counts? The Bank has just published its own assessment.
On interest rates, it concludes that QE was effective in reducing risk-free interest rates (gilt yields). However, even for the very few companies that can borrow in the bond markets, the effect on the interest rate faced by investment grade companies over and above this was virtually non-existent. The net result was a very modest reduction in the interest rate they faced (of around 0.7 per cent), which was dwarfed by changes driven by the evolving macroeconomic picture.
For the majority of companies that can only borrow from banks, even this small victory was absent. The Bank reported “little evidence that effective new bank lending rates for households or firms fell significantly following QE purchases”.
On the second slip, the evidence is pretty damning. Lending to private non-financial companies has fallen by more than 12 per cent since QE1 began in March 2009, and lending to small and medium sized enterprises has been even harder hit.
There are two reasons for the two slips. Risky interest rates remain stubbornly high. The banking sector is broken and is not transmitting monetary policy through to borrowers. And borrowing is shrinking for two reasons: over-indebted households and companies do not want to borrow at any interest rate. Among those that are not over-indebted, confidence is shattered – uncertainty is so high that few want to put capital at risk.
The verdict is already in. Indeed, the Bank’s governor has given it on countless occasions: monetary policy cannot save the economy. Seriously negative interest rates might work – but only at the cost of debauching the currency, which is the last refuge of a desperate government. Since the governor rejects both this and fiscal stimulus, his only remedy seems to be to grin and bear it until the global economy is set to rights.
The most terrifying thing to emerge from the Bank of England’s reports is that the Bank embarked on its experiment without any macro-economic model specifying how money was to be transmitted to income. In other words, QE was launched on a wing and prayer.
So it is up to the politicians to rescue the economy from years of stagnation. As I have said before, we urgently need a Plan C: a strategy for investment and growth. The chancellor will have a chance to unveil one in his pre-budget statement of 29 November. But will he have an ace up his sleeve?
Robert Skidelsky 